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Amazon Gains from Holiday Spending

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Amazon.com’s (AMZN - Analyst Report) fourth quarter earnings of 21 cents missed the Zacks Consensus Estimate by 8 cents (27.6%). However, shares appreciated 8.9% in extended trading, more than making up for the 5.7% decline during the day, due to operating margin improvement for the first time in five quarters.

Revenue

Amazon reported revenue of $21.3 billion, up 54.0% sequentially and 22.0% from the year-ago quarter. This was in line with the guidance for the quarter of $20.3-22.8 billion (up 55.7% sequentially, or up 23.3% year over year at the mid-point), although short of our expectations. Year-over-year revenue growth was 23% excluding unfavorable currency impact.

Around 57% of sales were generated in North America, representing a sequential increase of 54.4% and a year-over-year increase of 23.0%. The balance came from the International segment, which grew 53.5% sequentially and 20.8% year over year (23% excluding unfavorable currency impact).

Active customer accounts increased by 12 million to more than 188 million. Active seller accounts stayed above 2 million. Paid (third-party) units were 39% of total units in the third quarter, compared to 41% in the second quarter.

Key strategies for driving revenue growth remain a vast selection, competitive pricing, free shipping, user experience on Amazon properties and the Amazon Prime program. Fulfillment centers are also important, since they are essential for providing the level of customer service that Amazon customers have come to expect of the company. Over the past year, Amazon has been investing heavily in fulfillment and technology & content.

Segment Details

Amazon’s North America Media business was up 31.1% sequentially and 13.3% from last year to 14% of total revenue. The consumption of digital content across categories is helping the business. While selling and lending books on the Kindle platform continues, Amazon is also developing its direct publishing business.

Additionally, titles were expanded to 36,000 movies and TV episodes in the last quarter. Amazon’s reach and value proposition are making it a key player in the video distribution business. The category saw strong double-digit growth in four of the last five quarters.

The Electronics and General Merchandise (EGM) business in North America (40% revenue share) was up 68.0% sequentially and 23.6% from last year. EGM is a more seasonal business with holiday-driven spending having a significant impact.

This seasonality has increased manifold since Amazon launched the Kindle platform. Therefore, year-over-year comparisons are more meaningful. We see very strong double-digit growth in each quarter since December 2009, which is indicative of the expansion in the market and Amazon’s growing position within it.

Amazon’s International media business (17% of total revenue) was up 51.4% sequentially and 4.8% year over year. EGM, which was around 26% of total revenue, grew 55.3% sequentially and 34.7% from last year. This seems to indicate a greater preference for purchasing electronics rather than content in international locations.

Once the electronics business gains momentum and Amazon has enough fulfillment centers set up, we expect further investment in content. Amazon now has Kindle stores in Brazil, Canada, China and Japan where thousands of local language books are being sold. Therefore, new product categories, better selection within categories, competitive prices and free shipping remain drivers.

The Other segment, while still small (around 4% of total revenue, mostly in North America) includes Amazon Web Services (AWS). The North America business grew double-digits from both the previous and year-ago quarters. Growth in the international business was strong on a sequential basis, but not with respect to the comparable quarter of the prior year. During the year, AWS launched 159 new services and also reduced prices.

Gross Margin

The gross margin shrunk 113 bps sequentially and expanded 347 bps year over year to 24.1%. Sequential variations in gross margins are usually largely mix-related, although pricing is growing into an important factor given the increase in product categories all over the world.

The fact that new product launches come hand in hand with extra launch costs, is also a negative for the gross margin. Third party sites are also doing well, which has a positive impact.

Gross profit dollars were up 47.2% sequentially and 42.5% from last year, due to volume changes. The increase from last year is very encouraging, indicating that any margin declines are being more than compensated by higher volumes. It also indicates that Amazon brings a value proposition for customers that make them stick with it.

Operating Metrics

Amazon’s operating expenses of $4.7 billion were up 34.5% sequentially and 41.5% from the year-ago quarter. Amazon’s heavy investing activities (headcount, fulfillment centers, content, etc) over the past few quarters have been driving up its costs. Specifically, fulfillment, marketing, technology and content, and general and administrative expenses as a percentage of sales were up 110 bps, 60 bps, 138 bps and 5 bps, respectively from a year ago. All except marketing costs were down on a sequential basis.

As a result, the operating margin of 1.9% was up 211 bps and 41 bps, respectively from the previous and year-ago quarters. The operating loss of $405 million was up significantly from a loss of $28 million and a profit of $260 million in the previous and year-ago quarters, respectively.

The North America segment operating margin was up 130 bps sequentially and 212 bps from the year-ago quarter. The International segment operating margin was up 177 bps sequentially and down 158 bps from the year-ago quarter (a lot of the investment over the past year was in this segment).

EBITDA was $1.3 billion, up 75.2% sequentially and 67.4% from last year. The cash margin of 6.1% was up from 5.4% in the previous quarter and 4.5% in the year-ago quarter.

Net Income

Amazon generated third quarter net income of $97 million, or a 0.5% net income margin, compared to loss of $274 million, or -2.0% in the previous quarter and income of $187 million, or 1.1% net income margin in the same quarter last year.

There were no one-time items in the last quarter. Therefore, the GAAP earnings were same as the pro forma earnings of 21 cents a share compared to loss per share of 60 cents in the previous quarter and profit of 40 cents per share in the year-ago quarter.

Balance Sheet and Cash Flow

Amazon ended with a cash and investments balance of $11.4 billion, up $6.2 billion during the quarter. The company generated $5.1 billion of cash from operations, spending $2.0 billion on fixed assets (including internal-use software and website development costs), $35 million on acquisitions net of cash acquired and $156 million to pay down debt and long term obligations. The huge improvement in the cash position was partly on account of $3.1 billion raised through long term debt offerings during the quarter.

Amazon saw inventories increase 19.1% sequentially, with turns increasing from 8.1X to 10.7X. Receivables increased in the quarter, with DSOs dropping a couple of days to 14.

Guidance

Management provided guidance for the first quarter of 2013. Accordingly, revenue is expected to come in at around $15.0-16.6 billion (down 25.7% sequentially, or up 19.8% year over year at the mid-point), below expectations of $16.9 billion. Operating income/loss (including $285 million for stock based compensation and amortization of intangible assets) is expected to come in at approximately -$285 to $65 million.

Our Take

There was little change in Amazon’s fourth quarter barring a strong holiday season, which led to a slight improvement in the operating margin that we can only describe as seasonal. Therefore our thesis remains unchanged.

We continue to believe in Amazon’s prospects, especially its platform approach (Kindle, Prime and the still small but growing AWS). We think that Amazon is performing true to form, continuing to grow revenue and generate very strong cash flow quarter upon quarter (discounting seasonal variations).

As such Amazon remains one of the leading players in the fast-growing ecommerce market. The increase in users, units and partners overall indicates that it is outgrowing the ecommerce market. We think that this has been possible in the past because of the broad selection, free shipping and user experience that Amazon has consistently provided. This has enabled the company to gain from the shift in offline to online consumption.

The Kindle platform will remain a major growth platform for Amazon. Despite the Mini from Apple, we think Amazon devices come with their own value proposition, so there will be many takers.

Amazon has the huge task of maintaining its U.S. market share and expanding globally. We expect share losses, but think that the market will expand fast enough for Amazon to maintain a solid growth rate.

However, this is dependent on its own capacity to serve customers, especially in international markets, where growth rates are likely to be higher and its own facilities fewer. As a result, both fulfillment and technology & content investments will likely continue to grow. We do not consider this negative, since differentiation among online retailers is very difficult and better experience and support are the things that can drive traffic.

While the increase in operating expenses is a negative impact on the bottom line, we believe this is necessary. We expect the operating leverage to translate into accelerated growth in future quarters. However, the uncertainty regarding the timeline remains, which is the reason we remain Neutral on the shares.

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